Together or Apart? Eco-friendly location under fiscal competition

Parallel to governments’ fiscal policy competition to attract a foreign firm, countries’ attention to environmental damages grows. This paper analyzes fiscal competition between two asymmetric-sized countries under production-based pollution. An indigenous local firm exists in a large country, and two countries design a lump-sum fiscal policy for a multinational enterprise (MNE) outside the region. We find that fiscal competition changes the equilibrium location of an MNE from the large country to the small country when interregional trade costs are sufficiently small. Moreover, we show that whether a change in the MNE’s location due to fiscal competition leads to eco-friendly location depends on how superior clean technology the MNE owns. Besides, we find that fiscal competition can improve welfare in competing countries simultaneously: the small country successfully attracts the MNE with a tax because the counteroffer by the large government has a heavier tax whereas a large country benefits from losing the MNE through less environmental damages.